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The EOQ formula

By Girijesh Pathak, www.niapune.com


Here we derive a formula for Economic Order Quantity (EOQ) for single item deterministic and constant demand and lead time. As the name indicates EOQ is a quantity that we order in every order and it is economical too, to the extent that it minimizes the total cost. As discussed earlier, we will consider three components in the total cost, ordering cost, inventory carrying cost and cost of items. Let us introduce following notations here, Total demand in the plan period for the item = D units. Cost of placing one order = A Rs. Unit cost of item = v Rs./ unit Rate of inventory carrying cost = r fraction of average inventory value. Order quantity = Q units/ order. Recall at this stage that all such costs that are not dependent on order quantity should be clubbed together as Cost of placing the order. These costs will be incurred whenever an order is placed or machine is set etc. Whether you order or produce 100 units or 500 units or anything else, it hardly matters here. Also, all such costs that are directly proportional to the level of inventory maintained are clubbed together in inventory carrying cost. Rate of inventory carrying cost here is taken as a fraction or percentage. If an organization maintains an average inventory of say Rs. 50000 or any other value and it has to pay an interest of 10% on the amount it borrows than this 10% qualifies to be a part of rate of inventory carrying cost. All such costs will be put together to reach at a value of r. Now Total Cost (C) = Ordering cost + Inventory carrying cost + Cost of items. Since total demand is D and in each order we order for Q quantity, we will have to make orders D/Q number of times. No. of orders in the plan period = D/Q Each order costs A Rs. So, ordering cost = AD/Q

Now, to find an expression for inventory carrying cost, think about the average inventory level. In a deterministic situation with constant demand and lead time, one places an order in such a way that when the stock position touches zero, the next lot arrives. At the arrival of a lot, Q units replenish the inventory because Q was the order quantity. Thus inventory level rises to Q + 0 = Q. Since the consumption rate is constant, the inventory level fluctuates between a maximum of Q units to a minimum of 0 units at constant rate. So the average inventory level will be (Q + 0)/2. So, the average inventory level = Q/2. Average inventory value = Qv/2. Here we simply multiplied the average inventory level by unit cost to get the average value of inventory. This is the amount getting blocked in inventory on an average. Since r is the rate of inventory carrying cost in fraction, Inventory carrying cost = Qvr/2 Cost of items for total demand of D units at the rate of v Rs./unit will be Dv. Thus Total cost (C) = AD/Q + Qvr/2 + Dv. .................................. (1) Here A, D, v and r are all estimated or forecasted values known to us. We are trying to find the order quantity Q that will make the total cost C minimum. So, C is a function of Q. We will use the concept of Maxima and Minima of Differential Calculus to find the value of Q for minimum C. This will give the Economic Order Quantity. Rate of change of C with respect to Q is given by dC/dQ which is differential coefficient of C with respect to Q. Differentiating the expression (1) for C with respect to Q we get dC/dQ = -AD/Q^2 + vr/2 For maxima or minima dC/dQ = 0, hence -AD/Q^2 + vr/2 = 0 or, AD/Q^2 = vr/2 or, Q^2 = 2AD/vr which gives Q = Sqrt (2AD/vr) .............................(2) This Q can give maxima as well as minima. To check for maxima or minima we will have to differentiate dC/dQ again. So d^2C/d^2Q = 2AD/Q^3

If we analyse 2AD/Q^3 we find that this expression will always give a positive value for positive A, D and Q. Hence the value of Q obtained above in (2) is for a minima. Thus Economic Order Quantity = Sqrt (2AD/vr)

Now you give a thought on the values of ordering cost and inventory carrying cost when we order for EOQ in every order and see if there is any relationship between the two.